Momentum is a measure of the speed and velocity at which a security, stock or trading instrument changes its price. Investors can determine the strength or weakness of a trend by determining the rate at which the price changes over time. Momentum stocks are those that move in accordance with momentum.

Investors use momentum to trade stocks during an uptrend. They buy shares and sell them when the trend is down. A stock can show bullish momentum if the price is increasing or bearish if the price is falling.

Investors need to know when to invest with or against momentum.

Key Takeaways

• Momentum is defined as the speed of change in price for a security, stock or trading instrument.
• Momentum is the rate at which prices change over time. This helps investors to determine the strength of the trend.
• Investors trade stocks based on momentum. A stock may exhibit bullish (the price rises) or bearish (the prices fall).

Calculating Momentum

Many charting programs and investing sites can measure the momentum of a stock, so investors do not have to calculate it. It’s important to know what factors are included in these calculations so that you can better understand how a stock’s trend or momentum is determined.

John J. Murphy, author of “Technical Analysis of the Financial Markets ,” explains in his book:

The market momentum is calculated by taking the price difference over a set period. Subtract the previous closing price from the 10-day closing price to construct a 10-day trend line. The positive or negative value of the cost is plotted around a line zero.

The formula to calculate momentum is:

• • Momentum=V-Vxwhere:V=Latest priceVx=Closing pricex=Number of days agoMomentum=V-Vxwhere:V=Latest priceVx=Closing pricex=Number of days ago

 

Momentum as a Strength Indicator

Momentum is the rate at which stock prices rise or fall over time. Momentum can be viewed as an acceleration or deceleration in the price movement of a stock. For example, if XYZ stock rose in price from $1.00 to $1.02 the first two trading days, then to $1.04 the next two and $1.06 the next two. This continued until the stock reached $1.22 on the tenth. The closing price of 10 days ago is used to calculate the difference between $1.22 and $1.02.

If all the other results from a 10-day trend were also upward, then it could have momentum when plotted onto a chart with previous results.

The momentum of an asset is, therefore, a good indicator of its strength or weakness.

 

Measuring Momentum

When measuring momentum, technicians typically use a timeframe of 10 days. The chart below shows momentum plotted against the S&P 500 Index. This is a good indicator of trends for the entire stock market. Note that the chart below is only intended to be used as an example. It does not include index prices.

The positive number is plotted (from the equation) if the latest closing price is higher than the previous closing price. If the most recent closing price of the index is higher than the closing prices 10 trading days ago, then the positive number (from the equation) is plotted above the zero line.

The zero line is an area in which the index or stock may be trading sideways or has no trend. The momentum line (blue) will move away from the orange line once a stock has gained momentum, whether it is bullish or negative.

Using only the momentum indicator and not the S&P price, we can tell that the index is likely to have rallied along with the large spikes above zero in the momentum indicator. In the opposite direction, the index is expected to have fallen on large moves downward below zero.

When we overlay the S&P 500 index with the momentum, we see that it correlates fairly well with the index.

• • • In the summer of 2016, we saw the S&P 500 trading sideways (orange box).
    • In September 2017, we saw both the S&P and momentum breaking out (orange Arrows), with the S&P finally reaching 2,875.
    • Between January and December of 2018, momentum started to collapse and fell below zero. (pink arrows), dragging the S&P along with it.
    • The market rallied early in 2019. But momentum turned bullish once again, breaking over zero. Meanwhile, the S&P raced up to around 3030.

From the chart above, we can see that if momentum is above zero but not trending higher, it can eventually lead to the S&P’s price falling—as in the case of May through September 2019 (in between the two pink arrows). Investors and traders closely monitor the movement of momentum and the S&P because if they are not in sync, there is something wrong. The S&P, or the momentum, needs to be adjusted.

 

Special Considerations

The downtrend may not be over just because the momentum indicator moves below the zero line and reverses direction in an upward direction. The downtrend will slow down. It is the same for plotted momentum above zero. A trend may not be established until a few movements above or below the line zero.

Many factors are responsible for momentum. The Federal Reserve’s monetary policies, economic growth, and earnings reports all impact companies and their stock prices.

In other words, momentum is not a predictor of price movements but rather reflects the mood and fundamentals in the market. Geopolitical risks and financial risks can also drive momentum, and therefore money, into or out of stocks. Investors need to be able to identify the market’s current momentum. However, they should also know what is driving that momentum and, ultimately, price movements.

 

What is the best indicator of momentum strength?

Many other indicators can be used to gauge price momentum and strength. The relative strength indicator is the most commonly used momentum strength indicator, but there are many others.

 

What does a high-momentum stock mean?

Stocks with high momentum are those whose price change is consistently higher than zero.

 

What is a good momentum score?

Analysts are the ones who usually determine momentum scores so that good results will depend on their scoring methods. When you use closing prices to calculate momentum and plot the results, any price changes above zero are considered good.

 

The Bottom Line

Momentum can be used to measure the strength of price movements and how they will develop in the future. As with many other price-based indicators, its measures can be compared to other technical or fundamental information to look for divergences.

You can trade on the go. You can trade anywhere, anytime.

You are about to trade on one of the largest crypto-asset exchanges in the world. You can trade securely with competitive fees and dedicated customer service and support. Binance’s tools will make it easy for you to manage your auto-investments and view price charts. You can also make conversions without any fees. Join millions of investors and traders on the global crypto markets by creating a free account.